At the start of the year, many market commentators began to see a faint glimmer at the end of the interest rate tunnel.
While inflation climbed to 7.8% over the December quarter, it was lower than the Reserve Bank of Australia’s forecast of 8%. So some thought the RBA might stop its monetary policy tightening at its February meeting. Instead, a hawkish RBA lifted the cash rate for the ninth time in as many meetings, before warning of “further increases in interest rates”.
I’d be very supportive of these rate rises if they were working. But it’s become increasingly clear they’re not defeating inflation. Worse, the RBA is pouring more fuel on the fire by indirectly enabling rent rises (now) and price growth (in the future) in many parts of Australia.
Why the RBA has gotten inflation all wrong
The RBA likes to remind us that it is “resolute” in its determination to return inflation to its 2-3% target range, and that the short-term pain will be worth the long-term gain.
In theory, increasing the cash rate should reduce inflation. That’s because higher rates should reduce spending and investment activity, which should reduce demand and inflationary pressures. Recent Australian Bureau of Statistics data seems to vindicate this approach, with retail sales volumes falling 0.2% over the December quarter when compared to the September quarter.
In practice, though, this approach is misguided. That’s because Australia’s inflation problem has not been caused by ‘demand-pull inflation’, which is when too much money chases too few goods.
Instead, it’s been caused by ‘cost-push inflation’, which is when businesses are hit with higher supply-side costs – such as higher energy prices due to the war in Ukraine – and pass these on to consumers.
The RBA acknowledges this, estimating in its latest statement on monetary policy that “supply shocks account for around three-quarters of the pick-up in inflation” in Australia.
Generally, cost-push inflation is caused by global factors beyond our control, so Australians buying less stuff will have little to no effect on it.
Why rate rises will bring more pain than gain
To make matters worse, the RBA’s aggressive monetary tightening is causing even more supply and demand imbalances, particularly within Australia’s property markets.
Australia is already in a grip of a rental crisis, with asking rents in the combined capitals jumping 24.7% in the year to February 12, according to SQM Research.
And the problem won’t disappear anytime soon. That’s because strong rental growth isn’t being caused by high interest rates; instead, it’s due to a lack of supply, with vacancy rates at historic lows in many rental markets.
Logically, increasing housing supply should help bring rents down – which, in turn, should dampen inflation. But higher interest rates are deterring property investors from entering the market. They’re also making it harder for developers to build new housing.
Fewer investors in the market means a reduced supply of rental housing. That means more demand, which in turn puts upward pressure on rents. We can see that playing out in front of our eyes right now.
The reduction in homebuilding activity will have impacts down the line. That’s because a reduction in the supply of new housing for owner-occupiers will lead to more demand, which in turn will put upward pressure on prices – and worsen the housing affordability problem.
That’s why I say that not only is the RBA’s interest rate policy not solving our inflation problem, it’s also risking real harm.
Rather than disincentivising investors and developers, what we need are policies that will increase the supply of rental stock and owner-occupied housing.